A common question small businesses have is how to record when a client or customer fails to pay an invoice. I’ll try to address some of the most common issues in this post.
Cash vs. Accrual
If you’re a cash-basis taxpayer, which most small businesses are, you’re not going to like what I’m about to say:
If a client stiffs you, it is a “tax nothing.” You don’t get a deduction … because you never included the client’s invoice in your income to begin with.
That answer makes clients very angry 100% of the time, but unfortunately it’s the correct answer. Let’s walk through why this is the proper treatment.
Cash-basis: When is Income Recorded?
A cash-basis taxpayer records income on their books when payment is received from the customer. If the customer never pays the invoice, you never recorded income on your books, therefore there is no deduction to take for the customer’s failure to pay.
Joe the Window Washer is a cash-basis business. He sends an invoice for $1,000 to a customer. No income is recorded on Joe’s books until the customer pays the invoice. If the customer fails to pay the invoice, there is no deduction to take because the invoice was never counted as income to begin with.
Accrual Basis: When is Income Recorded?
A taxpayer using accrual-basis accounting will record income on their books when the customer becomes obligated to pay the invoice. Generally this means when the business sends the invoice.
In this case, if the customer fails to pay, the business CAN take a deduction because they had initially recorded the invoice as income.
Joe the Window Washer is an accrual-basis business. He sends an invoice for $1,000 to a customer upon completion of a window-washing job. Because Joe is on the accrual basis, he will record $1,000 of income at that time. If the customer fails to pay the invoice, Joe will deduct $1,000 as a bad debt expense.
What About Sending a 1099?
Most business owners are entirely unsatisfied with the answers above and are looking for ways to get back at the customer who stiffed them. A recurring question is if the business can send a 1099 to the deadbeat customer.
I have addressed that question in a couple of different posts through the years:
- Issue a 1099-C to a Deadbeat Customer or Client?
- Issue a 1099-C to a Deadbeat Customer or Client? Updated
The advice I give regarding sending 1099s is: I wouldn’t send a 1099 because I feel it would open a can of worms you probably don’t want to deal with.